When buying an investment property, you need to do your homework carefully to avoid your property becoming a financial ball and chain. While astute investors can make money, property has significant holding costs and is not as liquid as other investments.

For anyone considering buying an investment property, the good news is that we could be seeing the first signs of improvement for rental yields after several years of weak performance.

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According to FNB Property economist John Loos, since 2013 the gross average yield on properties has been declining, falling from 9.22% to 9.07% in early 2016. The yield is determined by the rental income relative to the value of the property. As property prices strengthened, so the rental income relative to the value declined. However, Loos believes that as property prices start to weaken this year, so the relative yields will start to rise. There are also indications that rental escalations are starting to increase, with rental inflation outpacing weak house price inflation.

Due to a weaker economy, rental escalations fell as low as 2.8% year-on-year in 2015, yet recent figures show rental escalations increasing to around 4.25%. Given these increases, Loos expects average gross yields to gradually increase to 9.3% during 2017.

Don’t try to time the market

Head of Credit at FNB Home Loans Tommy Nel warns however against trying to time the market when deciding to invest in property. “The best approach in my opinion is not to get carried away with the braaivleis talk and get-rich-quick tips being shared and looking at property to make a quick buck.” Nel says for an individual who has a least a five-year time horizon in mind, property can deliver a reasonable return as long as you are not buying into a property bubble or the area in which you bought does not go into decay. It also requires that good occupancy levels are achieved when rented out.

Andrew Van der Hoven, Standard Bank Head of Home Loans says it is important to fully understand your financial position before making the decision to purchase. “Owning multiple homes also has costs that should be taken into account, such as insurance, renovations, garden services, and rates and taxes.  If the property is a sectional title, then levies need to be factored in.” It is important to also make sure you have at least three to six months’ worth of payments in reserve to cover you if  a tenant defaults, or if you can’t find a tenant to occupy the property.

“Consideration should not only be given to finances, but to the property itself. You should, for instance, find out more about the area in which the house is situated, the average value of properties in the suburb and take time to have the house examined for possible defects such as poor plumbing, potential electrical problems and structural concerns.”

Do your homework on the area

Before buying a property find out about rental demand in the area – for example areas close to universities or large call centres may have a higher demand for rental accommodation. Investigate what you could realistically get for the property in terms of rental by going through advertisements for rental properties of a similar size in the area, although keep in mind tat a landlord may get less than the advertised amount. Also remember, estate agents can hype up the potential rental return in a bid to sell the property.

You also need to be realistic about your annual rental increases. Based on information from Tenant Profile Networks (TPN), escalations are only around 5% per annum currently, even though running expenses such as levies and rates may be increasing at a faster rate.

How much of your mortgage will the rental cover?

Before you buy a property, make sure you have done all the calculations to ensure that the rental you will receive less the costs and maintenance makes it a viable investment.

Example of a rental property based on a 9% gross yield

This means you only have R4 100 in rental income that can go towards paying the mortgage on the property. This would pay for a mortgage of around R400 000.

Will the banks lend you the money?

Gone are the days when you could just borrow money to buy an investment property. With the new affordability rules set out in the National Credit Amendment Act, the banks have to follow a strict set of criteria when assessing affordability, and that does not necessarily include your rental income.

Head of Credit at FNB Home Loans Tommy Nel explains that even though the the property being acquired is for investment purposes, banks cannot consider any potential income streams from the property that do not already exist. Nel says even if you purchase a property with an existing tenant, the seller would have to provide bank statements to show they actually received rental from the tenant. “Once a formal lease agreement is in place and the regulatory requirement of being able to validate the income a landlord receives under the lease has been met, then FNB will use the rental income earned in doing our NCAA compliant affordability assessments.”

What this means is that the rental income can only be taken into consideration once the tenant is paying, so in most cases rental agreements can be used in affordability assessments to buy further properties, but not your first.

So if you want to buy an investment property, you will have to put down a pretty big deposit and be able to fund the monthly instalment from your salary. If you have an existing home in which you are living and which is financed, it is unlikely that you will have the spare money to fund an investment property.

However, if for example, you have an existing apartment and you want to buy a bigger property or are moving in with a partner, you could find a tenant for your existing apartment and use that income as part of your application for a new property.

Ewald Kellerman, Chief Risk Officer at Absa Retail says it is important to keep in mind that the income you receive from a rental property is taxable. “Interest on a bond and some maintenance costs are often allowed to be deducted as an expense, which can reduce the taxable amount considerably. Certain capital gains exemptions also only apply to your primary residential property, but not to an investment property. Make sure that you take this into account when calculating total return, and consult a tax practitioner to understand the full tax implications.”

If you have a residential home and an investment property, you want the bulk of the mortgage to be on the investment property in order to benefit from the tax deductibility of the mortgage.

Managing tenants

TPN Credit Bureau has a database which provides information on tenants’ payment behaviour. This can provide information on whether the tenant can afford the rental and if they are good payers. They also provide an online property management solution which sends invoices, captures expenses and generates reports for the landlord.

Investing in property versus shares

Over the last ten years, residential property has underperformed the JSE. The July 2016 Absa Price Index shows that over ten years property prices rose by 72%, yet over that time the JSE All-Share-Index, with dividends re-invested, increased by 225%. In other words, a R1 million investment in property would be worth R1.7 million while an investment linked to the average return of the JSE with dividends re-invested would be worth R3.4 million.

Even in high growth areas like the Western Cape, property is not necessarily an outperformer. An acquaintance recently sold their house for R8.5 million having bought it six years ago for R5 million with no mortgage. On paper that is a massive R3.5 million profit ‒ it is these large capital figures that attract people to property in the first place. Yet if they had invested the R5 million in the JSE, the returns, with dividends re-invested, would have been marginally higher and the holding costs significantly lower. They have not factored into their profit the negative cost of home maintenance, fairly extensive renovations, rates and taxes.  On purchasing the property, transfer duties and bond registration costs would have been incurred, and in selling agent fees would have been paid. An investment in shares would not have incurred these costs, resulting in a much higher return.

So why do people bother with property at all? It all comes down to rental income and the ability to leverage the property. Rental can provide a steady income or allow a tenant to pay back a mortgage on the property.

If, for example, my acquaintance had rented out their property, the rental income would have significantly boosted their overall return, adding over R2 million in rental income over that period. If they had borrowed money to buy the house and had only put down a R1 000 000 deposit and had managed to rent it out at a rate that paid the mortgage in full and covered the running costs, then effectively they would have turned R1 000 000 into R3.5 million profit – a very different return scenario.

But this only works if your rental yield is sufficient to cover your costs. If, for example, your rental income only pays for the interest on the property and you have to supplement the mortgage payment, then you could have invested that money into the stock market with a lot less hassle. Admittedly, over time, if your mortgage repayment remains static, your rental escalations would eventually increase significantly to cover the full mortgage and then even the running costs, but this takes time and is certainly not a short-term proposition. You also have the risk of interest rate increases which would require you to pay in additional money to cover the mortgage.

As Ewald Kellerman, Chief Risk Officer at Absa Retail says, the capital return alone is unlikely to make the property a good investment, and one would have to ensure that the property generates a sufficient total return after subtracting costs to determine if the investment is worthwhile.

Be careful of going blindly into property ownership, there are significant risks and you need to understand your costs and potential returns. It is not necessarily less risky than investing in the stock market.

This article first appeared in City Press.